| A health savings account is like a personal savings account that can only be used for qualified health-care expenses. An HSA allows anyone with a qualifying high-deductible health plan to set aside pretax money to pay for approved medical expenses. Like any other financial tool, HSAs have pros and cons.
HSAs have more tax advantages than flexible spending accounts and 401(k) plan accounts. If you contribute by paycheck deduction, those funds are pretax. Your employer, a relative or anyone else can contribute, and those funds also are tax-free. Withdrawals aren't taxable as long as the money is used to pay for qualifying health-care expenses.
You can keep contributing to an HSA if you're not working and deduct them on your federal tax return. The money you put in your HSA has no expiration date and will stay in the account forever. This means that unspent money in an HSA rolls over at the end of the year, so it's available for future health expenses.
At age 65, funds used to pay for non-medical expenses are taxable, but there is no 20% tax penalty. Some people use their HSA nest egg to buy investment property.
Typically, there is no minimum deposit required to open an HSA account. Also, HSAs are portable, which means you own the account. If you leave your job, you can take the HSA with you.
HSA funds can be used to pay for qualified medical expenses for your spouse and dependent children, even if they are not covered under your HDHP. After retirement, funds can be used to pay for Medicare or Medicare Advantage plan premiums (but not Medigap policies).
It is, of course, important to consider the potential disadvantages of using an HSA.
For example, there are some potential tax drawbacks. If you withdraw funds for non-qualified expenses before you turn age 65, you'll owe income taxes on the money plus a 20% penalty. Once you're 65, you'll owe taxes but not the penalty.
Expenses can be audited by the IRS so you should keep receipts for all payments made with HSA funds. Some HSAs charge a monthly maintenance fee or a per-transaction fee, which varies by institution. While typically not very high, the fees are almost certainly higher than any interest that the account may earn and do cut into your bottom line.
Once an individual reaches age 65 (the age for Medicare eligibility), additional contributions (including catch-up contributions) can no longer be made, even if you are still employed. So, if you don't stop contributing to your HSA six months before you apply for Social Security benefits, tax penalties may apply.
The bottom line: If you are enrolled in a HDHP, the tax advantages of an HSA and the ability to roll over unspent money can be appealing. HSAs do have fewer limitations and more tax advantages than FSAs. Savers who want to set aside money for health-care costs may have access to an HSA or FSA — or possibly both, depending on an employer's benefits plan.
While both offer tax advantages, it makes sense to do your homework and compare the two type of accounts and find out which works best for your life situation.
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